This article is designed to identify those issues that a borrower in Central and Eastern Europe should be thinking about if its mortgage loan appears to be heading towards a default situation, and, in the event a default occurs, what the leading considerations of the borrower should be in formulating its strategy to achieve the best possible outcome. This article is not a review of laws in any jurisdiction, and we do not delve into the legal minutiae of how a lender may enforce security interests in a particular jurisdiction. Instead, we seek to set out a general approach for borrowers on how to deal with problem mortgage loans in the CEE.
A. Background
Commercial mortgage financing is a relatively new practice area in the CEE, having only developed in the last fifteen years. The lending market has historically performed well, so in contrast to other economies which have previously lived through periods of defaults and workouts there is comparatively little experience both in the legal system and among market players in terms of dealing with defaulted commercial mortgage transactions. Based on knowledge of the legal system in place and the market, we can suggest a way forward for borrowers. Before proceeding on this path, we will take a brief look at the basics of the legal system, as this is the framework in which workouts will play out.
1. The Legal System
a. Collateral Enforcement
The primary remedy available to lenders under legal systems throughout the CEE is foreclosure on loan collateral that is then sold at auction. Such sale procedures may be judicial (requiring the involvement of the courts) or non-judicial (whereby the lender can avoid having to go to court to enforce). In certain jurisdictions the availability of a non-judicial right of sale depends on whether this was agreed as an available remedy when the loan was originally documented.
b. Taxation
Whenever property is transferred, there is usually a transfer tax, stamp duty or similar payment obligation. Transfer tax is also applicable in a collateral enforcement scenario, although the amount of such transfer tax may be less than would be the case in a regular transfer (for example, currently the transfer tax rate in Hungary for an enforcement situation is 2% of the value of the collateral as opposed to the normal transfer tax rate which is 10%).
In addition to transfer taxes, most countries have a taxation regime for forgiveness of indebtedness. So, for example, if instead of going through an enforcement procedure, a borrower were to hand over the keys to a property to its lender in exchange for the lender forgiving the debt owed by the borrower, and the value of the collateral is less than the amount of the debt that is owed, the portion of debt that is forgiven would be taxable.
c. Bankruptcy
As a general rule, the failure of a company to promptly file for bankruptcy when it is insolvent can lead to harsh penalties (in some cases including personal liability of directors, shareholders, and/or criminal liability). Proceedings can either lead to a court ordered liquidation (sale of assets) or in limited cases to a reorganization. In addition to "voluntary" bankruptcy filings by debtors, "involuntary" filings may occur by creditors commencing bankruptcy filings against debtors.
It should be noted that typically liquidation would be the outcome of bankruptcy proceedings, because in commercial mortgage loan transactions there is usually only a single important creditor and if agreement could not be reached with that creditor previously it is unlikely to be achieved during a reorganization. As a result, unless the borrower has other significant creditors (such as contractors, or in the case of residential apartment projects, purchasers under pre-sales), it is unlikely that borrowers would be able to benefit from reorganization laws.
Following a bankruptcy filing by a borrower, in certain CEE jurisdictions the sale of assets would be run by the bankruptcy court or administrator in an open process and it may be difficult or impossible to agree a negotiated transfer to the mortgage lender.
2. The Market
The vast majority of commercial mortgage lenders in the CEE are banks, although some companies that are engaged in leasing may also have a license to do bank lending. Such institutions typically do not have asset management arms such as life insurance companies in the United States or pension funds in Canada, who engage in both lending and ownership of property.
The typical structure for a commercial mortgage loan would be for a single purpose vehicle to own a single property and for the loan to be secured by a mortgage on the property, a pledge of shares in the SPV, a pledge over the bank accounts and an assignment of rents. It is not uncommon to also see portfolio mortgage loan transactions where an SPV holds several properties or where multiple borrowers each hold properties and a cross-collateralized and cross-defaulted structure is put into place.
In the CEE, there are numerous construction loans that are in existence due to the boom in construction until this downturn. In addition to the collateral described above, well-advised construction lenders would have required assignments of construction documents and "step-in" rights for such loans, pursuant to which the general contractors agree contractually with the lender to fulfill their obligations to construct the project in the event of a default. Construction loans also have as part of their documentation cost overrun guarantees, pursuant to which a deep pocket guarantees payment of construction costs in excess of the development budget agreed with the lender. Construction loans have unique issues and in the context of this primer will be discussed separately from investment loans.
B. Approaching a Default
So you are a borrower of an investment commercial mortgage loan in the CEE, in the second year of a five-year term loan from a lender and the real estate downturn is upon you. What should you do?
1. Loan documentation
A good place to start is to conduct a loan audit (that is, a review of the loan documentation by the borrower or its lawyers) to ascertain those provisions that are most likely to cause a default under the loan. Such provisions include financial covenants and certain default provisions, such as those related to leasing or material adverse change.
Discover any defects in the loan documentation, such as whether the lender's lawyers failed to register a certain security interest or encumber a portion of the property with a mortgage? Did the lender put into place a non-judicial enforcement mechanism? Knowledge of such defects or potential sweeteners that could be offered up will be a useful tool later during the negotiation of a workout. Borrowers should also be aware of the requirements of the loan documents as they pertain to valuations and the delivery of additional information so as to be able to control, and if necessary, limit, potential overreaching by lenders.
2. Focus on communications with your lender
The basis of any workout is trust. If it becomes apparent that a default is imminent, it would be appropriate to alert the lender to this fact and for the borrower to offer up a plan to deal with it. This lets the lender know that the borrower is aware of the situation and in control of it and builds a basis for further cooperation. Lenders tend to react badly when they hear about problems at a property from a source other than their borrower.
In the course of such communications, the borrower must be very careful not to unintentionally trigger an event of default (for example, by admitting that it is unable to meet its debts as they fall due, which potentially could be tied into the insolvency default) or open up problems that did not previously exist.
C. Default
It is common that a lender will not immediately call an event of default. In part, this is because they do not want to carry problem loans on their books (which generally involves greater administration responsibilities internally and potentially negative effects on reserves, balance sheets or credit ratings), and also because the lender would prefer for the situation to be resolved and may feel that there is a possibility to do so within a relatively short time-frame. If the borrower commenced communications before the default and the process was already being managed at an early stage there is a greater likelihood that the "default" will not become an "Event of Default."
If a breach of a loan agreement arises and cannot be quickly remedied and there is no agreement among the borrower and lender to restructure the loan, the lender is usually in a better situation to achieve its aims if it calls an event of default, in which case it would typically send out a default notice. It will also freeze the bank accounts of the borrower pursuant to rights under account pledges as a first measure. The lender, however, will also be analyzing the benefits and down-side to calling an event of default. For example, relying on a "material adverse change" default provision may be difficult to prove and could result in counter-claims for damages if in reliance on such default the lender triggers cross-default provisions contained in other loan agreements of the borrower or its affiliates.
If the lender is on shaky ground in calling the default, then the lender may need to be reminded by the borrower of the potential liabilities it could face as a result of any actions taken in wrongly calling a default. Wrongfully calling a default may give rise to a damages claim against the lender, for example, if the borrower's reputation is hurt or if the wrongful default results in tenants backing out of leases or an apartment developer losing sales; however, proving such damages may be difficult.
D. Enforcement or Workout
Once the default notice arrives, the borrower should already have determined whether it is in its best interests to (i) attempt a workout and retain the property, (ii) attempt a workout with the goal of disposing of the property on the best possible terms, (iii) fight the default and the actions of the lender, or (iv) hand over the keys. The lender will also have made a determination as to what it would like to achieve.
1. Workouts to Hold
Workouts require both parties to arrive at a win-win situation. In other words, unless each party sees a benefit to doing a workout, it is unlikely to happen. This will require the lender and the borrower making concessions. If the borrower has as its goal the retention of its property, it will want (i) an agreement on the part of the lender to agree not to foreclose, (ii) possibly additional funding, (iii) additional time and (iv) easing of covenants or repayment terms. The lenders will want (i) the borrower to acknowledge defaults, (ii) more information and security, (iii) waiver of liability, (iv) a mechanism for swift foreclosure if the forbearance conditions are not met and (v) control over cash generated from the property and control over strategy.
If the lender is unwilling to cooperate, it can be enticed by some of the items listed above. This would be an opportune moment to point out to the lender any deficiencies that were discovered in the borrower's review of the loan file that could be fixed if the lender were to cooperate.
2. Workout to Exit
If the borrower determines that it is unable to hold the asset, it is still in the interests of both parties to work together to achieve maximum returns and minimize cost. For example, the parties could agree that the lender will forbear from enforcing its collateral provided the borrower agrees to market and sell the property. Selling the property through a reputable broker without the market knowing about the distress will lead to a higher price than at a foreclosure sale. If the initial purchase price is deemed too low, then the parties might agree on how to bring the price higher. This flexibility is not available in a foreclosure scenario.
3. Handing Over the Keys
It would also be possible for the borrower in certain cases to hand over the keys to the property, although the legal regime in the CEE does not provide an easy mechanism to do this. Such agreements could be done at either the share level or the asset level, although they have different implications for the lender both from a transfer tax and liability perspective.
From the borrower perspective, if handing over the keys is combined with a forgiveness of debt, there would be likely be negative tax consequences to the borrower as the portion of debt that is forgiven would be taxable, and this needs to be taken into account. From the lender perspective, if the borrower had other creditors, then handing over the keys may be subject to attack by such other creditors if it is done to their detriment. Therefore, these arrangements will need careful structuring and consideration.
E. Bankruptcy
One of the tools in the borrower's arsenal against the lender following a default is the threat of a bankruptcy filing and as outlined above, in certain cases such a filing is mandatory. That said, a bankruptcy filing in the CEE is unlikely to be a solution for the borrower where there is just the single important creditor. Instead, the borrower is likely to lose control over the property, incur legal expenses and lose any equity in the property as a result of a liquidation sale. Despite the problems relating to bankruptcy, borrowers should keep in mind that it may be possible to file for bankruptcy in other jurisdictions which provide better protections for borrowers and a greater chance for survival.
From the lender's perspective, a bankruptcy filing is likely to delay its ability to enforce its collateral, remove its ability to acquire the property, and will almost certainly result in the borrower not making payments for a period of time. The threat of a bankruptcy filing may push lenders to enforce instead of agreeing to a workout; so, as part of any workout strategy, borrowers will have to expect increased monitoring and reporting so that the lender can track cash flow. In addition, lenders may require an equity injection (which may also come from any collateral in excess of debt service at the property) to insure the borrower does not become insolvent.
F. Construction Loans
A default in a construction loan presents the lender with a very difficult situation, because most lenders are not equipped to be able to step into an ongoing construction loan to take over the project and complete construction. Simply owning completed properties requires staff skilled in asset management, which many lenders do not have, and properly running a construction project requires even greater monitoring, administration and specialized knowledge. In addition to the staffing issues, the remedies that are available to a construction lender are far more limited than in an investment loan and few construction loans in the CEE are backed by full payment and performance guarantees. In order to have the benefit of existing permits, it is likely that the only avenue available to the lender is through enforcement of the share pledge (but this in turn, means inheriting the liabilities that are embedded in the borrower). In order to complete construction and have an income-producing property, it will need to come out of pocket and keep current the payments to the general contractors. It will also need to engage in lease-up and deal with all the other tasks that the developer would otherwise handle in order to have a viable, income-producing project. Few situations require the borrower and lender to work together to arrive at a viable solution more than a defaulted construction loan.
G. Conclusion
Instead of waiting for impending doom, borrowers should prepare for the possibility that their loans may go into default and prepare a strategy for dealing with this eventuality. Alternatives between enforcement of security and bankruptcy exist. By taking the initiative and engaging skilled advisors to assist in the workout process, borrowers should be able to shape the CEE marketplace to make it friendlier to borrowers than might otherwise be the case.
Defaults And Workouts Under Commercial Mortgage Loans: The Lender Perspective
This article is designed to identify those issues that a lender in Central and Eastern Europe should be thinking about if its mortgage loan appears to be heading towards a default, and, in the event a default occurs, what the leading considerations of the lender should be in formulating its strategy to achieve the best possible outcome. This article is not a review of laws in any jurisdiction, and we do not delve into the legal minutiae of how a lender may enforce security interests in a particular jurisdiction. Instead, we seek to set out a general approach for lenders on how to deal with problem mortgage loans in the CEE.
A. Background
Commercial mortgage financing is a relatively new practice area in the CEE, having only developed in the last fifteen years. The lending market has historically performed well, so in contrast to other economies which have previously lived through periods of defaults and workouts there is comparatively little experience both in the legal system and among market players in terms of dealing with defaulted commercial mortgage transactions. Based on knowledge of the legal system in place and the market, we can suggest a way forward for lenders. Before proceeding on this path, we will take a brief look at the basics of the legal system, as this is the framework in which workouts will play out.
1. The Legal system
a. Collateral Enforcement
The primary remedy available to lenders under legal systems throughout the CEE is foreclosure on loan collateral that is then sold at auction. Such sale procedures may be judicial (requiring the involvement of the courts) or non-judicial (whereby the lender can avoid having to go to court to enforce). In certain jurisdictions the availability of a non-judicial right of sale depends on whether this was agreed as an available remedy when the loan was originally documented.
b. Taxation
Whenever property is transferred, there is usually a transfer tax, stamp duty or similar payment obligation. Transfer tax is also applicable in a collateral enforcement scenario, although the amount of such transfer tax may be less than would be the case in a regular transfer (for example, currently the transfer tax rate in Hungary for an enforcement situation is 2% of the value of the collateral as opposed to the normal transfer tax rate which is 10%).
c. Bankruptcy
As a general rule, the failure of a company to promptly file for bankruptcy when it is insolvent can lead to harsh penalties (in some cases including personal liability of directors, shareholders, and/or criminal liability). Proceedings can either lead to a court ordered liquidation (sale of assets) or in limited cases to a reorganization. In addition to "voluntary" bankruptcy filings by debtors, "involuntary" filings may occur by creditors commencing bankruptcy filings against debtors.
It should be noted that typically liquidation would be the outcome of bankruptcy proceedings, because in commercial mortgage loan transactions there is usually only a single important creditor and if agreement could not be reached with that creditor previously it is unlikely to be achieved during a reorganization. As a result, unless the borrower has other significant creditors (such as contractors, or in the case of residential apartment projects, purchasers under pre-sales), it is unlikely that borrowers would be able to benefit from reorganization laws.
Following a bankruptcy filing by a borrower, in certain CEE jurisdictions the sale of assets would be run by the bankruptcy court or administrator in an open process and it may be difficult or impossible to agree a negotiated transfer to the mortgage lender.
2. The Market
The vast majority of commercial mortgage lenders in the CEE are banks, although some companies that are engaged in leasing may also have a license to do bank lending. Such institutions typically do not have asset management arms such as life insurance companies in the United States or pension funds in Canada, who engage in both lending and ownership of property.
The typical structure for a commercial mortgage loan would be for a special purpose vehicle to own a single property and for the loan to be secured by a mortgage on the property, a pledge of shares in the SPV, a pledge over the bank accounts and an assignment of rents. It is not uncommon to also see portfolio mortgage loan transactions where an SPV holds several properties or where multiple borrowers each hold properties and a cross-collateralized and cross-defaulted structure is put into place.
In the CEE, there are numerous construction loans that are in existence due to the boom in construction until this downturn. In addition to the collateral described above, well-advised construction lenders would have required assignments of construction documents and "step-in" rights for such loans, pursuant to which the general contractors agree contractually with the lender to fulfill their obligations to construct the project in the event of a default. Construction loans also have as part of their documentation cost overrun guarantees, pursuant to which a deep pocket guarantees payment of construction costs in excess of the development budget agreed with the lender. Construction loans have unique issues and in the context of this article will be discussed separately from investment loans.
B. Approaching a Default
So you are a lender of an investment commercial mortgage loan in the CEE, in the second year of a five-year term loan with a borrower and the real estate downturn is upon you. You have read that a major retailer that occupies a number of properties securing mortgage loans is on the verge of bankruptcy, or the latest valuations have shown a significant fall in loan to value ratios. What should you do?
A good place to start is to conduct a loan audit (that is, a review of the loan file by the lender or its lawyers) to ascertain that all original loan documentation is in the loan file and fully executed, all security required to have been delivered is in place and has been properly registered, recorded or filed, as appropriate in order to perfect the security interests that were granted by the borrower and priority of such security interests has been preserved. Likewise, collateral registers should be checked to see if new liens have been filed or recorded: are there any junior lien holders? Confirmation should be obtained that the borrower is current in its tax payments, as such claims sometimes take priority over mortgage liens in a bankruptcy event. In order to understand options, a check should be made that the loan documents contain all appropriate enforcement mechanisms, including non-judicial alternatives, where available. Confirm whether there are any parent or bank guarantees available, what obligations they cover and are there circumstances where the lender might inadvertently end recourse under such guarantees through the exercise of rights or remedies.
Discover any defects in the loan documentation or collateral package and if possible, try to fix them. While loan agreements should contain provisions that require borrowers to cooperate, ideally, a request to fix a problem should be made in connection with a borrower request for a consent, amendment or waiver.
Increased monitoring may be appropriate to understand the financial position of the borrower, its property and its tenants. The condition of the property may also be a question and so an inspection may be advisable. It is vital to understand the underlying cause of problems, in order to be able to formulate a strategy if a default arrives. Is the problem a result of general market conditions that has brought values down, or is there a third party that is responsible, such as a bankrupt tenant? While loan agreements will define what information needs to be delivered on a regular basis (financials and valuations), a well-drafted facility agreement will also permit the lender to request additional information.
Whenever approaching a default and in the time period after a default, there is always the potential for litigation or for mistakes to happen that could become the basis of litigation, whether it is a bankruptcy of the borrower or a claim for damages based on lender liability or, as we shall explore later, the inadvertent creation of defenses that may become available to the borrower due to mistakes in communication by the lender. In order to minimize such possibilities, it is important to work closely with in-house legal teams or outside counsel.
In the current market climate in the CEE, lenders can anticipate that there may be several loans that will go into default and that in certain cases it may be desirable to take over ownership of properties (whether directly or by ownership of shares). In anticipation of such possibility, it is advisable to consider creating a holding company subsidiary in a low-tax jurisdiction so as to achieve the most tax-efficient structure upon an eventual sale of the collateral.
Although one of the options that may be available to a lender at any time is to sell a loan, we do not consider this alternative in the context of this article.
C. Default
Sometimes it is unclear whether a default has occurred or not; this is often the case with provisions that contain a materiality standard such as "material adverse change" or "political and economic effect" provisions. Whether a strong argument can be made that an event of default has occurred in such circumstances will require analysis which may extend beyond the particular loan under examination and take into account whether there is a consistent approach by the lender under similar loans. Where the default is not evident, the lender needs to be cautious about actually calling an event of default because although wrongfully calling a default would normally in and of itself not constitute a breach of contract, it could carry with it a damages claim by the borrower, for example, if cross-default clauses were triggered or the default became known and the borrower's reputation were to suffer (resulting in tenants backing out of lease negotiations, for example).
The lender's reaction to a default depends upon the nature of the default, the trust level that has been developed with the borrower and the lender's strategy; however, lenders are usually best advised to send a default notice to the borrower. This not only puts pressure on the borrower to cooperate for a possible workout but also makes available enforcement options. If the loan may be converted into a demand loan pursuant to the terms of the loan agreement, this can also be done and if the circumstances warrant, blocking bank accounts is a straightforward initial remedy that will get the borrower's attention. This would also be an opportune time to request additional information from the borrower that may be needed to analyze the situation. Suggesting a possible meeting would also be appropriate, if there is an opportunity to do a workout.
In order to avoid any argument over whether notice was validly delivered, it is important to follow exactly the terms and provisions of the loan agreement in terms of who the default notice is addressed to, the method of delivery and content of the notice. As a general rule it is best to keep the default notice simple and clear.
There are times when moving straight to foreclosure (whether on the share pledge or mortgage) is the best strategy. Typically, this would be the case where the borrower is the cause of the default (for example, the borrower is causing intentional waste, by directing tenants to another building owned by it) or where the attitude of the borrower makes it clear that cooperation is very unlikely (such as where the borrower has initiated a lender liability claim); however, in most cases, at least exploring the possibility of a workout is a sensible initial strategy. Even if it is determined that ultimately the borrower will need to be dispossessed of the property in order to satisfy the mortgage debt, a workout that implements that solution should result in a higher realized value of the collateral and eliminate successful lender liability claims, delays and foreclosure costs.
D. Pre-Workout
Usually lenders will want to communicate with the borrower and obtain information in order to formulate a strategy to deal with the default. Unless the lender is simply asking for information, before speaking or meeting with the borrower in order to discuss possible options, it may be advisable for the borrower and lender to enter into a pre-negotiation agreement. Such an agreement should set the ground rules for negotiation, protect the lender's rights and remedies (confirming, for example, that no right or remedy is being waived by the lender entering into negotiations) and confirm agreement that no course of dealing will arise as a result of discussions that occur. The intent is to defend against possible arguments that the terms of the loan have been altered if negotiations fail and no workout agreement is reached. Keeping a written record of workout meetings and imposing deadlines is also advisable, to facilitate progress toward a satisfactory solution.
As a lender, it is important to keep in mind that it may be necessary to deal with third parties (which is partly why the loan audit was conducted) in addition to the borrower. For example:
- If there are subordinate lien holders to any portion of the loan collateral, any workout arrangement that modifies the terms and conditions of the loan or the security might need to be consented to by such lien holders and confirmation should be obtained that subordination will continue subsequent to such modification. Such consent and confirmation would mitigate the risk of any argument that the subordinated lien holder was put in a worse position as a result of the modification possibly entitling it to a better priority position than would otherwise have been the case.
- As with subordinate lien holders, guarantors might need to be asked to confirm that their obligations continue notwithstanding any workout.
- If a lender's title policy exists, in the event the loan terms are modified or additional property is given as security for the loan, it may be necessary to obtain endorsements to the policy (at the borrower's expense) to insure the continued lien priority of the mortgage (as the same may be modified) or a new policy for any new mortgage.
E. Workout Alternatives
Workouts may take the form of a simple modification of a loan agreement, changing the payment terms or maturity date, or they may be complex, pursuant to which the list of events of default are expanded or modified and the lender agrees to forbear from exercising its rights and remedies (sometimes referred to as a forbearance agreement or standstill agreement) provided the borrower complies with certain covenants (unless another event of default occurs).
Internal coordination within the lender is necessary in order to have an effective workout strategy. This involves not only the legal department but includes coordinating with any asset management division and the tax or audit division that can advise on the consequences of the different enforcement and workout scenarios. If such capability is not available in-house, then coordination with outside advisors is necessary.
Broadly speaking, there are three workout alternatives: (i) a workout where the borrower retains the property, (ii) a workout with the goal of disposing of the property on the best possible terms, or (iii) handing over the keys. Determining which strategy works best will depend on legal, economic and practical factors and market trends as well as the debt profile (the amount owed and maturity).
Collateral enhancements that could be used as part of a workout include various forms of guarantees and indemnities that are usually given by the parent company of the borrower or other entity in the equity chain. Such guarantees may take the form of a payment guaranty that becomes effective as soon as the workout is put in place and is enforceable upon the occurrence of certain events, such as the bankruptcy of the borrower, breach of any forbearance agreement or actions taken by the borrower against the lender (the initiation of lender liability claims or the raising of defenses against enforcement, for example), but is terminated if the loan is repaid or all loan collateral is transferred to the lender.
Adding new security from the borrower without new consideration can be problematic as such security interests may be subject to attack in a bankruptcy proceeding. Forbearance alone may be insufficient to support the security transfer.
If holes in the security package were not fixed at an earlier stage, any workout should include fixing any problems that were discovered in the earlier loan audit.
1 .Workouts to Hold
Workouts require both parties to arrive at a win-win situation. In other words, unless each party sees a benefit to doing a workout, it is unlikely to happen. This will require the lender and the borrower making concessions. If the borrower has as its goal the retention of its property, it will want (i) an agreement on the part of the lender to agree not to foreclose, (ii) possibly additional funding, (iii) additional time and (iv) easing of covenants or repayment terms. The lenders will want (i) the borrower to acknowledge defaults, (ii) more information and security, (iii) waiver of liability, (iv) a mechanism for swift foreclosure if the forbearance conditions are not met and (v) control over cash generated from the property and control over strategy.
2. Workout to Exit
If it is determined that the borrower is unable to hold the asset, it is still in the interests of both parties to work together to achieve maximum returns and minimize cost. For example, the parties could agree that the lender will forbear from enforcing its collateral provided the borrower agrees to market and sell the property. Selling the property through a reputable broker without the market knowing about the distress will usually lead to a higher price than at a foreclosure sale. If the initial purchase price is deemed too low, then the parties might agree on how to bring the price higher. This flexibility is not available in a foreclosure scenario.
3. Handing Over the Keys
It would also be possible for the borrower in certain cases to hand over the keys to the property, although the legal regime in the CEE does not provide an easy mechanism to do this. Such agreements could be done at either the share level or the asset level, although they have different implications for the lender both from a transfer tax and liability perspective. If the lender has the capacity to hold on to and manage real estate, obtaining the keys may be the best means of preserving value as the lender may be able to engineer the project back to a better position and sell once the market has turned.
From the borrower perspective, if handing over the keys is combined with a forgiveness of debt, there would be likely be negative tax consequences to the borrower as the portion of debt that is forgiven would be taxable, and this may need to be taken into account in order to implement such a strategy. From the lender perspective, if the borrower had other creditors, then handing over the keys may be subject to attack by such other creditors if it is done to their detriment. Issues relating to the right of redemption (the right of the borrower to obtain sale proceeds in excess of the debt) may also exist. Therefore, these arrangements will need careful structuring and consideration.
F. Bankruptcy
One of the tools in the borrower's arsenal against the lender following a default is the threat of a bankruptcy filing and as outlined above, in certain cases such a filing is mandatory. That said, a bankruptcy filing in the CEE is unlikely to be a solution for the borrower where there is just the single important creditor. Instead, the borrower is likely to lose control over the property, incur legal expenses and lose any equity in the property as a result of a liquidation sale.
G. Construction Loans
A default in a construction loan presents the lender with a very difficult situation, because most lenders are not equipped to be able to step into an ongoing construction loan to take over the project and complete construction. Simply owning completed properties requires staff skilled in asset management, which many lenders do not have, and properly running a construction project requires even greater monitoring, administration and specialized knowledge. In addition to the staffing issues, the remedies that are available to a construction lender are far more limited than in an investment loan and few construction loans in the CEE are backed by full payment and performance guarantees. In order to have the benefit of existing permits, it is likely that the only avenue available to the lender is through enforcement of the share pledge (but this in turn means that third party liability will remain with the borrower). In order to complete construction and have an income-producing property, it will need to come out of pocket and keep current the payments to the general contractors. It will also need to engage in lease-up and deal with all the other tasks that the developer would otherwise handle in order to have a viable, income-producing project.
The potential liability issues relating to construction defects need to be carefully understood where the asset is transferred to the lender (whether during construction or immediately following completion).
Because of the formidable complications relating to construction projects, few situations require the borrower and lender to work together to arrive at a viable solution more than a defaulted construction loan.
H. Conclusion
Lenders need to have a comprehensive strategy to deal with the real estate downturn. This includes instituting loan audit processes, coordinating with multiple internal teams or outside advisors (risk management, legal, asset management and tax) and maintaining a close watch on the loan portfolio. In order to deal with specific problem loans, however, a more flexible, case-by-case approach is desirable. There are proven workout solutions that can also be implemented in the CEE. Because this area of the law has not been significantly tested in the CEE, skilled and experienced advisors are required to help devise and implement such strategies.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
